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Reuse, Redevelop or Reconsider? Questions to Ask About Repurposing CRE Properties

Right-sizing and Reusing Space Can Be Both Opportune and 'Scary,' RCLCO Expert Adam Ducker Explains

(Getty)
(Getty)

As the economy wobbles in the wake of the pandemic and distressed commercial real estate assets hit the market in droves, the potential to right-size spaces and capitalize on demand imbalances could come in the form of converting existing spaces to a new use.

When getting into the redevelopment and reuse game, investors and forward-thinking tenants savvy enough to tackle feasibility studies, rezoning red tape and potentially pricey architectural rehabs could end up winning with this method in 2020 and beyond.

LoopNet spoke with Bethesda, Maryland-based real estate advisory service RCLCO’s Senior Managing Director and Director of Urban Real Estate & Public Strategies, Adam Ducker. Here, the industry veteran with several decades of tenure paints in broad strokes a dynamic picture of an endeavor that sometimes seems within reach, but often remains fraught with risk.

"I think that might be a key takeaway — that this exercise is not going to be free. But it still might be the right thing to do, even if it’s a little scary."

RCLCO's Adam Ducker

Adam Ducker (RCLCO)

With distressed real estate sitting vacant, does it make sense in some cases to convert a space to another use that’s more desirable or profitable?

The gateway observation is that reusing buildings is difficult. Commercial buildings are typically built for intended use, and not only is it difficult to convert them, it’s also very expensive.

When we look back at the last decade, the key takeaway is how little commercial real estate has been repurposed for something different. Not because of a lack of imagination, but because so many people went through the exercise of, “should we do this?” and came to the conclusion that it might be cheaper or better to tear it down and start from scratch. We have to acknowledge that as the history we have behind us.

With really well-located real estate, the values are very high, and demand is very deep, so it might pay to do it. There are a lot of places where land is cheap and available, but demand is probably modest, so I think it is a “haves and have-nots” landscape when it comes to reuse.

The hardest thing for small owners is that it’s also expensive to study. Say you have a 20,000-square-foot office building. To really figure out what it’s going to cost to convert it to something else might require architects and engineers, and market studies and financial analysis. I think sometimes people start going down the road and think, “I’m going to have to spend X amount just to get a better idea.” That scares them.

I think that might be a key takeaway — that this exercise is not going to be free. But it still might be the right thing to do, even if it’s a little scary.

When does converting a commercial real estate space simply not make sense? Do any of those rules change in a post-COVID-19 world?

In some ways, the most logical and easy example to consider is converting office buildings to multifamily, which is something a lot of people have danced around. Before, we knew that we had too much office space in many parts of America, especially too much dated office space in suburban markets, and so it seemed to make perfect sense. The building may have been very well-located relative to major metropolitan areas, but it just didn’t seem to have a future as an office, and so some of that space has been converted to residential, but it’s been very, very difficult.

"It’s not only that it’s expensive, but it’s hard to gain confidence in the analytics and direction you’re getting as well, so I’m sympathetic to small owners.

RCLCO's Adam Ducker

For one thing, the floorplates are complicated if they are large. If there is a lot of floor space deep in the building and away from windows, it doesn’t work for apartments, considering you may have to hollow out the core of the building to get enough light [for residential use]. By that time, the costs compared to new construction could make the project impractical. I think one of the things we’ve found is that the number of instances in which it’s actually worked out has been relatively few. Does COVID-19 make that any different? Maybe.

But it’s not just expensive, it’s hard. You hire one contractor that says the project needs an HVAC subcontractor, and so on, and one eventually says, “we’ll need to rip out everything and do it from scratch, and by the way, we should do it up to this code or standard,” and you don’t know if that’s good advice. So, it’s not only that it’s expensive, it’s hard to gain confidence in the analytics and direction you’re getting as well, so I’m sympathetic to small owners.

The other problem is that the economics of existing real estate has to be feasible. Hotel-to-residential conversion, for example, had a lot of energy around it in the last decade. But the hotel inventory never really got cheap enough to justify buying a hotel and converting it to small apartments by the time you figure out what it really costs to build. So maybe that will be different. Today’s suburban office demand or office demand in general might become so anemic that the assets could be worth [buying for the goal of reuse].

Or maybe the distress in the hotel sector will become so pervasive that those assets really will be dirt cheap, and we will see people with that strategy. There are groups around that have bought up hotels not just considering [the recession caused by] COVID-19, but as part of [an ongoing] strategy.

Re-zoning is tricky when it comes to converting real estate spaces and must be handled on a case-by-case basis within a local municipality. Are there any broad factors to keep in mind?

Zoning depends on jurisdictions, but one overarching problem presents itself with the reuse of retail in general. Most municipalities are still in the framework that retail produces lots of positive tax benefits.

[Authorities] can be resistant to see retail space used as something different. People may know that the retail market is not what it once was, and a space may already be vacant, but the industry is accepting the new normal slowly. In the meantime, it’s still hard to give up on the idea of it because it has a meaningful impact on the [municipal] budget when you lose that. So that stands in the way of converting the space and it also just takes time.

The other problem is that existing tenants often have covenants, and so when you convert the grocery anchor in your strip shopping center to a medical office or storage or something else, the other tenants get bent out of shape, or might even have some mechanisms to prevent it altogether.

What are some examples in which converting commercial real estate can be a smart play?

Retail-to-office conversion is not new in America. Typically, one sign of failed retail is that there’s no retail tenant for a space, but there’s an office tenant, particularly if they are heavily client-facing — think accountants, tax preparers, attorneys, medical offices and so on — and retail does potentially lend itself well to those users.

"The bottom line is that it’s easier to convert to another use when there’s a user that’s underserved."

RCLCO's Adam Ducker

That is certainly a better scenario than empty retail space, and so I think we will see more of that. It doesn’t tend to produce a lot of income, so it’s not a panacea, but it’s better than no income.

At the other extreme, in highly desirable urban areas you see more wholesale reuse of large-format retail buildings, like end caps on malls or department stores reused as offices. These are often a very creative, expensive redo as a 21st century-office, and other times, it’s a matter of just converting an empty Macy’s into a medical office building, for example.

It’s hard to know whether we’ll see a tremendous amount of that, though, because retail owners are competing with office building owners that also have space that’s hard to use, and it comes down to who can be competitive on rates.

The bottom line is that it’s easier to convert to another use when there’s a user that’s underserved. And those users of office space are not really underserved at the moment.

If a suburban shopping center was trying to re-lease that as office space, though, it’s possible that they have an advantage these days: with a dedicated front door, you don’t have to go through the lobby and you don’t’ have to wait for the elevator, which is top of mind in the age of COVID-19. I’m not sure that’s going to last forever, but I think at the moment, the opportunity to reposition retail as office space might have that advantage.

One of the things that we observe in reuse and redevelopment that’s been successful has been the conversion of existing historic industrial and warehouse buildings to cool, contemporary uses, such as residential, office and the like. That type of conversion tends to be in spaces that are proven to be desirable locations on the edge of urban environments that, in the post-COVID-19 world, we think will continue to be desirable.

There are, of course, interesting examples in which say, an architecture firm on the edge of a downtown Los Angeles transitional neighborhood buys a really old, 10,000-square-foot, quirky [former industrial] building and turns it into their cool headquarters, and I think that is what everybody is fantasizing about when they think reuse.

Speaking of industrial, the existing market is strong, but it also seems to be the go-to for conversions, as you mentioned. Does it work both ways — are other property types being converted for industrial use?

The industrial markets have been so strong that we are even seeing some of the shopping center retail owners reposition spaces for industrial users doing last mile distribution, local warehousing or logistics.

There is also some reuse of suburban retail for self-storage or consumer use storage, a market that has been robust, with strong demand. And the costs and complexity of that type of conversion are manageable.

Another question might be whether we start seeing conversions of not just the typical cool, brick old mill-type buildings of the [early 20th-century industrial past], but whether the sort of next generation of office buildings, those built in the early post-war years, will have some sort of interesting reuse potential as well. The most logical reuse might be contemporary, reimagined office space. There was also a wave of office-to-hotel conversion at the end of the 2010s — so maybe as the hotel market comes back, that could pick back up.

What about converting unused hospitality or resort assets now that recreation travel faces headwinds?

One area that has seen a bit of press around it, which remains an interesting proposition, is the idea of converting old motel stock in America: the motor court-motels with no lobby, where you pull up with your car. That might come back into fashion if people are less interested in the crowded lobby experience, which was a big driver of hospitality. We’re a bit resistant to focus on that because there is some chance that in a year this [coronavirus pandemic] will all be behind us. Maybe it will really change people’s behavior, but maybe it won’t. I don’t think we’ll see huge investment platforms mobilized around that. Maybe it just opens our eyes to potential ways to reuse aging building infrastructure that we already have.

Resorts are another prospect, as they are often in locations where tourism is the primary driver of value. We might see an uptick in people looking to convert some resorts to residential. We saw that in 2011- 2013, when owners of particularly large properties that were relatively hard to book in shoulder seasons or during the week, and had large suites, villas or townhomes, were converted to residential as a way of right-sizing the asset. We did work with resort owners who said that they might have taken a wing of a hotel and combined two or three rooms into a kind of condo and sold those off as residential.

The resort residential market has been very strong this summer, so it would be a difficult, but feasible, way for owners of resorts to generate cash. Take a wing of the building and sell it off as condos and you’ve generated $40 million – $50 million in capital.

Owners may have been kicking this idea around for a few years and they might say, “you know what, the hotels are closed or have closed; now is the time to do it.”

The product lends itself to it; the things that make it a place to go on vacation make it desirable as a place to own a second home or to even live full time [in a period of flexible teleworking].

The fractional private-residence club models are not completely dead, either. Maybe there will be some renewed energy around that using some of this inventory.

"Don’t panic because the headlines say retail is bad or office is dead, but also don’t kid yourself: recognize that there may be places in which supply and demand dynamics really are out of whack and it’s time to change the use even if the economics seem a little scary."

RCLCO's Adam Ducker

What other shake-ups might we see when it comes to conversions? What are some beliefs you might pass on to clients considering such a project?

What we’re seeing is what a lot of the headlines suggest, which is that there’s still lots of appetite around residential and industrial assets of almost all kinds, and very much uncertainty around office space. I think the world breaks down into people who were still bullish about office space in the last cycle and will continue to be so, and those who weren’t, who will now just reaffirm their beliefs.

One predicted area of change is in suburban office space, centered around this emerging school of thought that there may be a shift to a satellite office model, so suburban office real estate, in particular, might have some tailwinds coming out of this. I think it’s a plausible argument because it’s not only about coronavirus, it’s equally as much about people wanting to work remotely, or an entire company not necessarily all needing to be in the same building. That might be a relatively long-lasting phenomenon.

In retail, it’s the same thing — we tend to paint it with a broad brush, but an entire closed mall is different than a grocery-anchored shopping center. Both of those are very different in a high-end suburb than in a low-density, underbuilt, slow-growth exurb.

I think the key thing for small owners is to be “eyes wide open” about the nature of the market. Don’t panic because the headlines say retail is bad or office is dead, but also don’t kid yourself: recognize that there may be places in which supply and demand dynamics really are out of whack and it’s time to change the use even if the economics seem a little scary.

I think that was what happened last time [following the Great Recession]. People said, “maybe I’ll convert this office building to something else,” and that didn’t look great when there was just enough leasing activity at rents that were just high enough to hold on to the idea that it’s an office building. This time we’ll be past that.

We had almost the same conversation in [the] 1980s about housing. Then, people said, “it’s so expensive to buy these old houses and fix them up and rent them; who wants to do that?” And here we are, 20 years later, and it’s a huge business ranging from suburban single-family detached homes to urban townhomes and everything in between. And so maybe we’re ahead of our time thinking of doing almost the same thing with small commercial buildings, in particular.

Demand for housing has been really strong over the last two decades, though, while production has been short of demand, and we just don’t know if that’s going to prove to be true about office users or other potential users of that space. Some say now we have plenty of real estate and demand is not that strong, but it’s too early to tell how the current economics will play out. That’s the dilemma.

This transcribed conversation was edited for clarity and brevity.

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